"There are only two ways of telling the complete truth—anonymously and posthumously."Thomas Sowell

Tuesday, December 14, 2004

Tax Exemption vs. Tax Deduction

A Dec.14 Wall Street Journal editorial “Free Speech vs. Tax Code” is understandably worried that some 60 nonprofits are under investigation for political advocacy, with the implicit threat of losing their tax-exempt status. “We’re not convinced that prohibitions are needed,” says the editorial, “or that a tax exemption for a charity constitutes a subsidy.” Having started down the road of regulating political debate after the Nixon era, under the guise of “campaign reform,” the anti-democratic impulses are indeed becoming rather frightening. But I want to make a different point.

What is truly important to genuinely charitable organization is not tax exemption per se, but the ability to receive tax deductible contributions. This is a relatively unique instance in which a deductible expense for the person writing the check is not treated as taxable income for the organization receiving the check. This is a violation of tax symmetry – normally a sound principal of good taxation.

No genuinely charitable organization has any profits to tax, so tax exemption does not matter a bit. All income is devoted to the charitable purpose, either immediately or through an endowment. A nonprofit has no profits.

Problems arise, however, where an organization is engaged in a mix of charitable and commercial activities. The AARP sells financial services in competition with taxable firms, the YMCA sells health club services in competition with taxable firms, and not-for-profit hospitals and colleges compete with taxable hospitals and colleges.

If the Journal editorial had said, “We’re not convinced that a tax deduction for charity constitutes a subsidy” -- rather than a “tax exemption” – then they would be on firmer ground. If Smith gives away half his income to Jones, then Smith no longer has that income to tax. Jones has it. What is a deductible cost to Smith should normally be taxable income to Jones, even if Jones is really a charity (in which case it won’t matter).

To exempt earnings from the sale of services from taxation simply because an organization is “doing well by doing good” is an open invitation to tax avoidance. To allow the government to censor political critics by changing their tax status is an open invitation to political abuse. Those are two big issues, but it is best to keep the distinction clear.

Many self-styled tax reformers are curiously eager to limit or end any deduction for charitable contributions. Yet they rarely tackle less-defensible business tax exemptions for many large service providers simply because the capital of those tax-exempt enterprises was financed by gifts and debt rather than equity.

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